Financial Stability Board Consults on changes to FX benchmarks

The Financial Stability Board (FSB) established the Foreign Exchange Benchmarks Group in February this year to undertake a review of foreign exchange (FX) benchmarks, and to analyze market practices in relation to their use and the functioning of the $5trn a day FX market.

The final conclusions and recommendations of the Group will be transmitted by the FSB to the Brisbane G20 leaders’ summit in November. As part of this process, the Group led by Paul Fisher of the Bank of England and Guy Debelle of the Reserve Bank of Australia, has published an interim report which sets out fifteen preliminary recommendations. These were drafted following its previous engagement with a wide range of FX market participants across the globe as well as its own independent analysis. In summary, the report is proposing possible recommendations for reform in the FX market in the following areas:

the calculation methodology of the WM/Reuters (WMR) benchmark rates;

the publication of reference rates by central banks;

market infrastructure in relation to the execution of fix trades;

the behavior of market participants around the time of the major FX benchmarks (primarily the WMR 4pm London fix);

consider recommendations from a forthcoming IOSCO review of the WMR fixes.

In response to the publishing of the consultation paper James Kemp, Managing Director of the Global FX Division of the Global Financial Markets Association (GFMA), commented: “The draft recommendations outlined are likely to have an impact on all participants offering or making use of FX benchmarks as part of their FX trading activity, including dealers, institutional investors, companies and governments.” Kemp outlined the critical function of the market adding – “We will continue to work with regulators and supervisors to support measures designed to preserve and enhance confidence in the FX market, given its role in underpinning global trade and investing.”

In its investigation, the FSB’s Group found that activity in foreign exchange markets is 10 times greater during the one-minute period used to set the so-called 4pm London fixing price than at any other periods of heightened volatility, such as the release of US data at 1.30pm London time. As the graph above demonstrates, it is this crucial trading period that is the subject of over a dozen regulators wide-ranging international investigations. To determine whether traders colluded with counterparts at other firms to manipulate important benchmarks rates such as the WMR. To date, more than 25 traders have been fired or suspended by the firms across the industry signaling the likelihood of some malpractice.

The 4pm benchmark price is important to asset managers, who use it to value their investments, and sovereign wealth funds and large corporates, who want to ensure they trade at the “fix”.

The FSB explains that: “The result of this activity by their clients leads to a concentration of trading orders being transmitted to dealers, in large part shortly ahead of the fixing time. In order to manage the risk associated with this client order flow, dealers hedge by executing foreign exchange transactions in and around the calculation window, which results in the large spike in trading volume. This creates a market where the dealer is agreeing to execute these orders at an unknown price, which is established subsequently during the fixing calculation window,”

“At a minimum, this market structure creates optics of dealers ‘trading ahead’ of the fix even where the activity is essentially under instruction from clients. Worse, it can create an opportunity and an incentive for dealers to try to influence the exchange rate – allegedly including by collusion or otherwise inappropriate sharing of information – to try to ensure that the market price at the fix generates a rate which ensures a profit from the fix trading,” the regulatory body added.

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